- Why is it so darn difficult
for active investors to outperform a basic index fund?
Let's talk about that.
Then I'll let you in on a little secret
as to why I'm kind of happy that people
are out there trying to continue
to outperform index funds.
Actively manage funds outperform the market.
There, I said it because that is a 100% factual statement.
Don't believe me?
So far this year, roughly 70% of actively managed funds
have outperformed a simple S&P 500 index fund,
but it's not the whole story.
And if I was trying to take your money
through investing in my fund,
then I could make that claim with no issues.
First, we need to understand why these actively
managed funds even exist
if it's so difficult to beat a dumb boring index fund.
The simple answer is money.
They make lots and lots
of cold hard cash from investors like you.
Look, the investment world is extremely competitive.
They have to be with a ton of money already flowing
into index funds to the tune of 11 trillion.
At this point,
these non index funds are playing for the leftover scraps.
Think about it.
Even if they convince a fraction of a percent of you
to invest in their more expensive actively managed funds,
they'll become rich and leave you holding the bag.
I'll show you how they're leaving you holding the bag
in a minute, so hang tight.
Just for fundies,
let's calculate how much inactively managed fund would make
by stealing a small amount of money
from the 11 trillion
that are currently invested into index funds.
Let's say the assets under management
for this actively managed fund is seven billion dollars
and they charge an expense fee of 0.75% per year.
I know seven billion dollars sounds like a lot and it is,
but it's only 0.063% of the 11 trillion
that are currently invested into index funds.
The actively managed funds would make a round,
wait for it, 52 million per year
for that 0.75% expense that they charge.
Imagine this scenario spread among hundreds
and hundreds of other actively managed funds.
Trust me, they'll come up with a random actively
managed fund for just about anything to make a buck.
So you see, these actively managed funds
don't need to compete with index funds.
They just need to be able to spin the narrative
in a way to get you to put at least a little bit
of your money into their fund over the index funds.
And it seems to be working because the comment section
of all of my videos are flooded with people telling me
about these rando actively managed funds
that they invest in.
Now, let me be clear.
If an actively managed fund actually brings enough value
to the investor to warrant that price that they're charging,
then I have zero issue with it.
I also like fair and open markets
where ideas have the opportunity to compete
to see which one is the best.
The problem is that most of them don't bring that value.
Let me explain.
Everything comes down to the value that you receive
for each dollar that you spend.
If I buy $1,000 worth of an actively managed fund
and they charge me me seven dollars and 50 cents per year,
then they better be bringing me enough value
to offset that cost because I could be investing that $1,000
into a simple index ETF where I paid 30 cents
per year and get average market returns.
It is 100% possible
for an actively managed fund to beat a simple index fund.
It's also possible for you to win the lottery.
But what they both have in common
is that neither of them are very probable.
At least with the lottery,
you are betting a little bit of money
for enormous potential returns.
With an actively managed fund,
you are betting a lot of money
for the potential of a very small outsized return.
The odds are so stacked against investors
from the very start, but the actively managed funds
will leave that part out of their marketing material
so you'll have no idea.
So stacked against you to the point where 96%
of actively managed large cap funds
underperform a basic index fund.
Yep, that means that only 4%
of them ended up ahead over 20 years.
It gets much worse for actively managed funds
the further we go out in time.
Now, you might be thinking to yourself,
"But Jared, I'm only investing five percent of my portfolio
into an actively managed fund just in case it outperforms."
Did you miss first grade math class?
Because that doesn't change the odds
and pretty much guarantees that that part of your portfolio
is going to underperform.
So keep telling yourself whatever story you want,
but that doesn't change the fact that
the tooth fairy isn't real
and Jeffrey Epstein killed himself.
You know how the lottery is basically a tax on poor people?
Well, I consider actively managed funds a tax
on uneducated people.
Oh, and I forgot to mention that after 20 years,
75% of those large cap actively manage funds
either completely shut down or merged with other funds
because the performance was so horrible
that they couldn't even show their faces
at Thanksgiving dinner any longer.
- Hey, ma, can we get some meat laugh?
- This isn't even a special case
with actively managed large cap funds though.
Here's a list of the rest of the fund categories
and how much actively managed funds
underperformed over 20 years.
This is how bad it is.
The best asset class
to gamble on would be an actively managed mid-cap value fund
and only 22% of them actually performed
better than the underlying index.
22%. Who in the world is handing out metals
for a 22% success rate?
I'll tell ya, nobody.
Well, in today's woke culture,
they're probably handing out trophies
to just about everybody.
All of this info is from the yearly scorecard
S&P Dow Jones' publishes.
The results end up the exact same every single year.
The financial advisor who has you in a bunch
of actively managed funds has a ton of explaining to do
if you show this to him or her.
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We need to talk about something
that just doesn't add up with this whole thing.
You've gotta imagine that most of the people
running these funds truly believe and act in a way
that'll help them gain an edge over a basic index fund.
So why can't more
of these actively managed funds outperform?
One of the reasons is because picking stocks
that'll outperform a basic index fund
is extremely difficult no matter how smart you are
or how much data you have at your fingertips.
To illustrate this, let's look at some research
done by the money managers, Blackstar Funds.
They pulled the data for total lifetime returns
of individual stocks from 1983 to 2006
and what they found was mind blowing.
The index they compared the individual stocks to
is the Russell 3000.
Now, this is a market cap weighted index
that tracks the performance of the largest 3000 US stocks.
Think of it as a total US stock index fund.
Kind of like the one that I talk
about a lot on this channel, which is VTI.
39% of stocks had a negative total return
which means that 61% of stocks had a positive return.
On the surface,
this seems like a good thing for actively managed funds
because they're buying up individual stocks
so the odds of getting a positive return
are definitely on their side.
Not so fast.
Just because these 61% of stocks
had a positive return doesn't mean the return
was good enough to outperform the index.
The point of,
and why you are supposed to be paying a high fee
to these active funds is to outperform
because if they don't, then why in the world
would you continue putting your money
into these funds instead of a basic index fund?
If we dig a little deeper into their findings,
we see that 64% of stocks underperform
the Russell 3000 index.
This means that the actively managed funds
you invested in would've had to have invested
more money into the 36% of stocks
that outperform because just investing money
into the winning stocks would not be enough.
The amount of dollars in those winners
would have to offset the losses they incur
from the money they surely invested into the stocks
within these 64% that underperform.
But wait, it gets even more difficult
for active investors to outperform.
Only 25% of stocks were responsible
for all of the market gains,
which means that a very small number of stocks
account for the majority of the stock market gains.
So if an active investor was somehow unlucky enough
to miss those 25% most profitable stocks
and instead invested in the other 75%
their total gain would've been wait for it 0%.
- Darn, it's gone.
- Picking those 25% more profitable stocks
are somewhat in the control of an active investor.
While not very easy or very probable,
it is within their control.
What's very rarely talked about are they things outside
of their control like timing.
Timing is a funny one because to be successful at it,
you have to be in the right place at the right time,
taking the precise action needed to make the most of it.
For instance, one of the most well-known successful
active investors, Peter Lynch,
ran the famous Fidelity Magellan Fund
from 1977 to 1990.
He returned an average 29% per year to investors.
This is absolutely insane by anyone's standards.
So remember, timing is everything.
The fund wasn't even open
to the public to invest in until 1981.
Four years later, from 1981 through 1990
when Lynch left the Fund,
it only returned an average of 22.5% per year
compared to the 16.5% for the S&P 500.
Don't get me wrong,
that's still a pretty darn healthy outperformance
so I'm not knocking it at all.
But once again, timing is everything.
If Peter Lynch would've used his same successful
investing style for the previous 13 years
before he started managing the Magellan Fund,
then his returns would've only been around 6% per year.
So you see, an active investor
can have a really, really good strategy
to help them outperform an index fund
but if they're too late,
too early or aren't implementing this strategy
during the perfect time period, then it doesn't matter.
This is why we have thousands
and thousands of active fund managers
and actively manage funds that no one remembers.
We only know about the very few most successful outliers
like Peter Lynch, Warren Buffet and Jim Simons.
And the people who are unimaginably good,
like Jim Simons keeps their investing strategies top secret.
He hasn't achieved average annual returns of 39%
since 1988 by telling the world how he invests
or starting in actively manage fund.
If he did that, then people would try to replicate
or front-run his strategy, which would destroy his returns.
Let's ignore the 22.5% returns for a second though
because that was dependent
on Peter Lynch and Peter Lynch only.
There are two other elements of timing that plays a role
in what kind of returns you as an investor
receive from these actively managed funds.
Firstly, to receive the full returns
like 22.5% from the Magellan Fund,
you would've had to have been invested
from the very beginning.
Most probably weren't
and jumped on board of the actively managed fund
after it had started performing very well
because humans are insanely irrational.
This is a mistake a ton of investors made
on a regular basis back then and continue to make today.
It's also why I constantly tell people
not to choose funds based on past performance
because those numbers are irrelevant
to someone getting in the fund today.
No one of course will listen to me
but I'll continue to shout that out
into space hoping at least one of you aliens hear me.
Secondly, even though the Magellan Fund
got a return of 29% per year,
Peter Lynch openly admitted
that the average investor only made
around 7% per year during these same time period.
How in the heck could that happen?
Simple answer.
Humans chase past performance then run for the doors
when it doesn't continue to perform the same way.
We see it all the time.
Money flows into the fund then flows out of the fund
because investors are irrational.
As many of you may not know, more money flowing
into an actively managed fund can be extremely problematic.
When an active fund manager performs very well,
we start to see a lot more money coming in
for them to invest due to their recent success.
You think this was a good thing
because more assets under management
means more money for them to deploy
into their successful investment strategy.
Bigger is not always better
and this is definitely the case with actively managed funds.
In fact, it can eventually be the downfall
of a very successful fund.
This is due to something called asset bloat.
If more money comes into their fund to be invested,
the manager has to find stocks
to invest in with that new money.
If he or she starts adding more money
to the same types of stocks, then that might overweight them
in certain stocks or sectors that would expose them
to different risk factors that they're trying to avoid.
Because of that,
the fund manager might have to start putting new money
into different sectors or stocks that don't 100% align
with the funds investment strategy,
which in turn will reduce the overall returns.
Now, a fund can avoid this issue
by closing itself off to new investors
but most of them don't because they're greedy.
More assets under management
means more money that they receive in fees.
Ego infects every single one of us.
And when money is on the line,
active fund managers are just as much if not more prone
to play into their ego as well.
As professionals, when they have a little bit of success,
they might chalk their success up to skill
when in reality they just got lucky.
In the short term, luck looks like skill
but over the long-term we find out who was truly lucky
and who was truly skillful.
MIT even found that the success
of mutual funds was do more to luck than it was skill.
Fama and French also came to the same conclusion.
Successful investing has more to do with luck than skill.
Even though that information is wildly known,
ego will always be there to drive active investors
to try to beat the market.
As a 100% index fund investor myself,
I'm actually pretty happy
that actively manage funds are out there
and people are continuing to invest in them.
The truth is that if everyone invested
in an index fund and nothing else,
there'd be problems since everyone would continue to pile
into the same stocks at the same rate.
Actively managed funds are needed for stock price discovery,
which is achieved when they're out there trading
in and out of things and constantly adjusting prices.
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